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Posted by: donmihaihai | February 22, 2009

Smart people, dumb money – a system that works

Have I made a mistake by buying into ARA Asset Management? A question that I asked myself after going through 4 REITs it managed — Amfirst REIT, Fortune REIT, Prosperity REIT and Suntec REIT. The 1st time I ever take a close look at REIT, property and asset management. While I can’t say much about property company, it was instantly recognisable that Asset management is one of the better business models around despite being competitive while REIT is where dump money goes, especially when they are selling at near NBV, NBV or above. That also mean dump monies were buying during IPOs and when REIT price keep going up. Because they are dump monies, they won’t take up prospectus, read a few pages and see how their REIT is being structured. They also won’t know that while they are “considered” the owner of the property say Suntec city, “employees” are making almost as much money without all the risk involved. These dump monies are happy with income of about 2.5% – 4% without leverage and 3%-5.5% with leverage. What are they hopping for, appreciation of property value and rental? Since property are value at fair value yearly, they must be hopping that property value and rental will keep going upward in double digit perhaps. Singaporeans bought REITs with CPF money are worse, basically dumb money X 2 because they are exchanging from an almost risk free return of 2.5% to 3% – 5.5% where the risk is way, way higher. Of course when the party was still going, who was complaining? Since ARA Asset Management is managing mostly REIT, the appeal of it goes down even it is in the asset management business. But well, I think, dumb money handing over to smart peoples is a system that works.

S-REITs are in a powerful whirlpool that perhaps created by themselves — all parties involved. I don’t know how it started but at double digit yields, all the refinancing, gearing talks and Right Issues are going to the extreme. 1st of all, if I understood correctly, while some REITs are weaker, all loans are performing loan. Not a single REIT default on their obligations yet. And property loan whether senior or junior, secured or unsecured, is being serviced by stream of rental cashflow from a matured property. For bank, this type of loan is considered as lower risk than many other types which include loan for developing property, corporate loan or personal loan. If investors are worrying about these loan, they should worry more on the refinancing risk of Hyflux, all property developing company, SIA and their own personal loan. For REIT, if their interest cover is 2X or for better safety, minimum 2.5 to 3X, they won’t have any problem service their obligations. Even if interest payment double while rental dropped by 50%, it is not the interest of the bank to pull back and let REIT default their loans. Maybe it is just me who don’t get it but if I am get unsecured loan at single digit interests, why not REIT with a big group of tenants. If anything that prevent them from getting it, it will be whatever stuffs other than gearing or cashflow.

Next, any investor who buys into REIT at double digit yield, eg Suntec REIT at $0.56, 20% yield, 0.28X NBV is clearly not looking at income alone, they are looking at income and all the appreciation in share price of Suntec REIT going forward. Which also mean, they are willing to take the swing in Suntec REIT price and income(yield). If the financing cost increased upward by 2X, it will chop off 1/2 of their yield in short term. Also, they know that there is no way they can buy similar quality property at the same price. Buying at current price also mean that they are willing to take the risk of potential short term zero yield for all kind of return in longer term. Don’t shout REIT is for yield, it is just a form, structure. Investment is for return, whether in income or price.

3rd, getting new capital through Right Issues or worse new investors. The managers are retiring cheap debt with expensive capital. Using cost of capital from finance text, they are using 20%(if Suntec REIT asking for Right Issue at $0.56) cost of capital to replace what is just 5% or 10% cost of capital. In short, destroying shareholder value(or unitholder value). Well, who owns the unit? They are looking at their ass as once done, they are cleared (safe). The cost of capital for new unit is not 20% because once issued, they will be always there sharing all future income. Cost of capital is higher. Cost of capital for debt is way lower than the 5%, 10% or even 15% because once it over and back to normal, refinancing cost will be lower as well. In time like this, REIT manager must bit the bullet, wait it out, refinance at higher cost.

Lastly, why ask for not paying tax if the payout ratio is <90%? In the 1st place, it is already unfair for not paying tax.

So much for REIT.

FY2008 results for ARA Asset Management was good. While it is likely that earnings peaked in last year, ARA will earns lesser(not too much) going forward until market is function more properly where they can launch new fund. Even if ARA earnings between $25-30million in next few years, it is still very good because free cashflow yield is in double digit.

It is good to know ARA is looking to launch fund cater to the current environment, I am not hopeful for one just like they said earlier that trying to launch a Japan property fund as it seem to be gone with the wind with no news. The ability to launch new fund depend much on the willingness of investors. And depending on fund size, with about $12billion AUM, another fund with ADF size won’t move the needle much or even fill up the gap as contribution from REIT start to drop as ARA earn more from managing REIT. But in the long term, there is no stopping ARA from managing $20billion or $40billion AUM. All it need is human capital, track record with reputation.

So for long term, rather than launching new fund now, ARA is better off working hard at getting out of that Whirlpool in S-REIT. Anything that bad for reputation and destroying shareholder value which is easily recognisable by other will be bad for the future of their business, especially as their track record is not long enough. It is the same for their private fund ADF. Since it is a limited period fund, timing is very important too, if ADF was launched 1 – 2 year earlier, ARA won’t be saying taking advantage of the current situation anymore. They will be trying their best not to loss money when the period end. Whatever their connection to Cheong Kong, they can only boast launching 4 REITs and a private fund earnings >20%. In fact, if I take away launching of 4 REITs, ARA has almost nothing much to boast. Now is the time to build solid foundation as years later when launching new REIT or private fund, ARA can proudly point to their records of sailing through the current crisis. That, I believe will gather more AUM.

And rather than giving 70% of earnings out as dividends, ARA must figure out that something got to give and find a sustainable strategy either by cutting dividends or start selling Suntec REIT units received. ARA cashflow from operating activities was $52million. Take $11 million out as it was from FY2007, ARA cashflow become $41million. But ARA spent $49million investing into Suntec REIT(I would say they were force to hold on to Suntec REIT units as units price slump too fast for them to get out in time when received for as managing and acquisition fees), ADF and AAIF. That is a deficit of $8 million, add in another $34.7million paid out as dividends, no wonder ARA cash is dropping like a stone.

While ARA started FY2009 with net cash of $23million, but it is committed to pay dividend of $13million, another potential $20million of commitment into ADF(timing and amount invest in FY2009 unknown). If ARA is going to earn around $30 million in FY2009, it is certainly unsustainable by not selling Suntec REIT units received for fees. Contribution from Suntec REIT in FY2008 is about $33million, half of ARA total revenues. This is without taking potential funding consideration from Amfirst REIT(high gearing and all short term debts), further investment into AAIF. ARA has a hard choice to make, 1) look stupid and sell cheaper Suntec REIT received in FY2009 while keeping higher price Suntec units, 2) cut all dividend payment, 3) take on expensive debt. I prefer ARA choose 2) as dividend can receive in any year and Suntec REIT is cheap. Beside by not selling them in the market can mean alot of intangible stuffs to many peoples beside investing along with unitholders which can’t be attained by selling them once ARA received it.

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Responses

I would agree that its much better for ARA to keep the Suntec REIT units that it received – which provides them with a cash flow through its own payout, and hold the prospect of better prices in the future. Its like your employer paying you with 10-20% interest on your pay, and compounded besides. Only thing is its not cash but if you can ride it out and they’ll be around to keep their promises – why not.

The attraction for REIT to me currently, is that the current environment will act as a brake for impulsive, acquisitive and ambitious managers – they will not be able to go off and buy stuff (or do stoopid things) even if they wanted to. I see it as positive because it forces them to focus on existing business as the S-REIT sector had too much hubris going for it over the past few years.

ARA should leverage up. If the banks are willing to lend, ARA should borrow as much as possible and pay out as much dividend as possible. Use the REIT units as pledge. Return the money back to equity holders. Let the bankers fund the business and take the risks. We need just 40cts/share of dividend to break even. Any upside on earnings will flow to equity holder. Any deterioration will be protected because equity holder has cashed out.